Answer to Question #32895 in Finance for Jenny

what impact might a significant currency depreciation of the US dollar have in the short run on US current account position?

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Expert's answer

2013-07-12T08:59:21-0400

The most obvious effects of dollar depreciation on the DP accounts are evident in the impacts on net exports, GDP, and prices.Current-dollar GDP: When the dollar depreciates against major foreign currencies, one generally expects to see current-dollar exportsincrease, as U.S. produced goods become cheaper abroad. The effecton current-dollar imports is more ambiguous: Depreciation increasesthe dollar cost of a given volume of imports, but the volume may decline to theextent that domestic goods and services are substituted for imports in responseto the increase in the relative cost of purchases from abroad.Assuming that the export stimulus effect and the volume effect on imports together outweigh the import-cost effect, dollar depreciationwould be expected to lead to an improvement in U.S. competitiveness, animprovement in net exports, and a corresponding increase in GDP.The price and quantity effects that move in opposite directions as a result of U.S. dollar depreciation are often difficult toidentify separately from movements due to other market forces. Forexample, dollar depreciation against oil-producing nations&rsquo; currencies wouldresult in an increase in the price of imported petroleum and a likely decreasein the quantity of petroleum imported -- the magnitude of the response would bedetermined by the product&rsquo;s elasticity (responsiveness to pricechange). However, other developments in the economy may also affectthe demand for petroleum, such as cyclical fluctuations or changes in fueleconomy, to a degree that often cannot be readily determined. Inaddition, the separate effects may be difficult to identify because the foreignsupplier may not fully pass through the costs associated with dollardeprecation or the domestic seller of the imported product may absorb some ofthese costs.Real GDP: The effect of dollar depreciation on real GDP is less ambiguous than the effect on current-dollarGDP. Assuming that it is possible for domestic production tosubstitute for imports, dollar depreciation will lead to increases inU.S.-based production as domestically produced goods are substituted forimported goods. This would lead to an increase in real GDP and adecrease in real imports. Dollar depreciation may also lead to anincrease in U.S.-based production for export, as foreigners substitute&ldquo;cheaper&rdquo; U.S. goods for goods produced in their own countries. Thisadded production would also lead to an increase in real GDP. Theultimate effect, however, of dollar depreciation on GDP depends on manyfactors, including the extent to which other countries adjust their owncurrencies in response to dollar depreciation.